Fixed Income Commentary - February 2018
As we close the books on 2017, fixed income investors find themselves in a familiar situation: Hoping 2018 will be the year that the U.S. economy breaks its multi-year trend of modest growth, ultimately leading to higher interest rates. Entering year nine of the current economic expansion, many of the pre-conditions are currently in place to foster higher inflation, growth, and interest rates. For one, the job market by most measures is strong, with the unemployment rate of 4.1% approaching pre-recession levels. The U-6 unemployment rate, which includes part time and marginally attached workers is the lowest since early 2007. In addition, U.S. initial jobless claims are the lowest since 1973. These indicators point to tightness in the labor market, which may finally spur wage growth and inflation. To this point, the Cleveland Federal Reserve’s measure of labor market tightness, the ratio of unemployed workers to job openings, is the lowest it has been in at least 15 years. While 20 states increased minimum wage in 2017, broad-based wage growth for all income earners has been elusive, keeping inflation at bay. The enacted Tax Cuts and Jobs Act has its critics, but it should provide a solid boost to the economy in 2018, also helping interest rates move upward. Amidst any possible inflationary pressures, markets will be intently observing the Federal Reserve’s actions and communication under the direction of new Chairman Jerome Powell. The interplay between higher rates, rising inflation, and Federal Reserve action will be a key theme in the year ahead.
Corporate credit had another strong year in 2017, buoyed by stable rates and tightening spreads to Treasuries. In the year ahead, headwinds include rising rates, increased merger and acquisition (M&A) activity, and somewhat full valuations. M&A activity in 2017 was well below a normal pace, although this is expected to reverse in 2018 as companies’ repatriated cash is used to fund growth. While M&A can often be seen favorably in the equity markets, resulting increases in an issuer’s financial leverage are generally a negative for bondholders. Therefore, avoiding sectors with elevated M&A risk (Telecom, Technology, Pharma, Consumer Staples) is still a key part of our strategy in 2018. In regards to valuations, spreads are tight but not historically tight. Pockets of value still remain in both Triple B rated (BBB) and cross-over issuers, which are companies with both High Yield and Investment Grade ratings. Aside from some of the headwinds, investor appetite for U.S. corporate bonds remains strong from both domestic and foreign accounts. On the aggregate, earnings for corporate issuers are robust and leverage remains manageable. Ultimately, keeping accounts slightly shorter in duration and being especially careful with credit selection should help investors limit interest rate, credit risk, and event risk. An overweight to corporate credit continues to be a main part of our taxable bond strategy, at least to start 2018.
In the municipal bond market, looming tax code changes contributed to most of the volatility in 2017. Following the 2016 presidential election, fears of drastic tax changes had the bond market starting 2017 from a position of weakness. As those fears proved mostly unfounded, municipal bonds rallied sharply in the first quarter, helping the Bloomberg Barclays 4-6 Year Municipal Index return upwards of 3% for the year. As it pertains to the municipal bond market, the major outcome of tax reform was limiting state and local tax deductions and eliminating the ability of municipalities to “advance refund” bonds. Capping the state and local deduction essentially means fewer ways to shield income from taxes, making municipal bonds even more appealing, especially in high tax states. Eliminating “advance refundings”, which is essentially the ability for a municipality to refinance debt early, may reduce new issue supply in 2018 by around 15%. Demand from banks is one area that necessitates close monitoring. Banks have more than doubled their holdings of municipal bonds since 2009, but the lowering of the corporate tax rate may reduce the appeal of tax-free bonds marginally. We expect bank demand to be steady, and the confluence of these technical factors should increase demand while reducing supply, supporting our positive view of the sector for the coming year.
A positive view on inflation and growth in 2018 informs our view that the 10-Year Treasury yield will approach or possibly exceed 3% by year end, and client portfolios should be positioned shorter in duration than their respective benchmarks. To be clear, with bond prices inversely related to market rates, higher yields will negatively impact bond values in the near term. Therefore, it is important to have a well-constructed bond portfolio, which can quickly benefit from increased yields when interest payments and maturities are reinvested at higher rates. While 2018 could end up being an incrementally more challenging year for fixed income, corporate bonds and municipal bonds should provide solid risk adjusted-returns, while also reducing portfolio volatility.
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Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some municipal security investors may be subject to Alternative Minimum Tax (AMT). Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.
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